Summary of New Paradigm for Financial Markets

“The new paradigm for financial markets: the crash of 2008 and what it means” is one of the latest books of George Soros. He has written eight other books on various subjects related to the economy. George Soros is a Hungarian-born American financial speculator, philanthropist, stock investor, and political activist. The estimated current net worth of George Soros is around $11 billion and he is the 29th-richest person in the world according to Forbes. George Soros is also a former member of the Board of Directors of the Council on Foreign Relations.

Summary

This book consists of two parts; the first part deals with the philosophical work (the theory of reflexivity and its application in the financial markets) of George Soros while the second part deals with the current financial crisis. The author is not satisfied with the prevailing paradigm of equilibrium theory which asserts that financial markets tend towards equilibrium. He proposes that a new paradigm should be adopted and one is readily available in the theory of reflexivity.

Part One

George Soros argues that there is big difference between the natural phenomena and social events. Natural phenomena deal with the direct relation of one set of facts with other while the social events are concerned with the facts, participant views and interrelation between them. It is due to these differences which compel the Soros to come up with the theory of reflexivity. According to this theory there are two types of function; cognitive function in which participants seek to understand the situation and manipulative function in which participants strive to change the situation. Both cognitive and manipulative functions work in opposite directions and, under certain circumstances; they can interfere with each other which is called interference reflexivity.

Since people are participants so they have to acquire sufficient knowledge to guide them in their actions. However people cannot base their decisions on the knowledge alone which is the underlying theme of fallibility. If people base their decisions on the knowledge the element of uncertainty that characterizes reflexive situations would be removed. So Without fallibility there would be no reflexivity. Similarly the understanding of people is imperfect because they cannot grasp the whole reality so they keep only a part of realty and derives from it; as a result their information is distorted. The basic idea of radical fallibility is that all human constructs are flawed in one way or another, although the flaws may not become apparent until a construct has been in existence for a while. It follows that flawed constructs can be stable for extended periods.

George Soros while criticizing the classical economic theory of equilibrium argues that this theory does not apply to the financial markets. Because in financial markets expectations play an important role so the contention that markets tend towards equilibrium does not correspond to reality. Similarly rational expectation theory is a case to which the postulate of radical fallibility applies because in this case too participants do not act on the basis of their best interests but on the perception of their best interest.

The prevailing paradigm suggests that since markets tend toward equilibrium therefore intervention of regulatory authorities is not necessary. This is the reason that market fundamentalists blame market failures on the fallibility of the regulators but they are half wrong: both markets and regulators are fallible. These uncertainties associated both with regulators and market participants are clearly recognized by new paradigm while the prevailing paradigm acknowledges only known risks and fails to allow for the consequences of its own deficiencies and misconceptions. Since the equilibrium theory has proven itself incapable of explaining the current state of affairs so recognition should be given to the reflexivity as it avoids making excessive claims about its ability to predict and explain social phenomena. But theory of reflexivity still has to prove its worth.

Part Two

There is no comparison between the current financial crisis and the other previous crisis and current crisis is worst since the great depression. The reason is that current crisis is not confined to particular segment of the financial sector rather it has brought the entire system to the brink of break down. Furthermore author argues that there is not just one boom-bust process or bubble but two; housing bubble and super bubble. These two types of bubble did not develop in isolation and are deeply embedded in the history of the period.

The housing bubble of United States started to develop after burst of technology bubble in 2000 and the terrorist attack of September 11, 2001. After these two prominent events there were more aggressive relaxation of lending standards and expansion of loan-to value ratio which results in the rise of housing prices, decline in saving and credit quality and growth of synthetic financial products. The cross-over point was reached in August 2007. The market recovery from August until October 2007 was followed by a collapse in January 2008.

George Soros believes that only housing bubble is not responsible for the current crisis but a big bubble which he calls a super bubble is playing its role in it. This super bubble appeared in 1980 because of ever increasing credit expansion, globalization of financial markets, and progressive removal of financial regulations and accelerating the pace of financial innovations. There have been a number of smaller bubbles and periodic crises within this super bubble. Each periodic crisis was resolved through quick action by the regulators, who intervened through some sort of fiscal or monetary stimulus. Thus, these smaller bubbles became successful tests that reinforced the super bubble and its claims of market fundamentalism.

In the past there was the trend that all economies of the world were badly affected by the crisis in the united state because of its immense role in the financial markets and world economy. But this time global recession is not expected because powerful expansionary forces are at work in other parts of the world and they may well counterbalance a recession in the United States and a slowdown in Europe and Japan. However the political consequences of economic development could disrupt the world economy. George Soros also believes that new bubbles are already in formation such as booms in raw materials, energy, and agricultural products and development of asset bubble in china. He also contends that current crisis is the end of era which means the end of a long period of relative stability based on the United States as the dominant power and the dollar as the main international reserve currency.

The current recession and flight of dollar are two important problems faced by United States. Due to losses and uncertainties in the banking system, burden of household debt and fall in housing prices the US economy is moving towards decline. Now the situation is very complicated because to combat this threat fed has increased the supply of dollar which resulted in the flight from US dollar. Due to lower demand for US dollar; inflationary pressures through higher energy, commodity, and food prices has been observed. On the other hand European monetary policy is conflicting with the US monetary policy. European Central Bank is unwilling to lower the interest rates because it wants price stability. Therefore Euro has appreciated more than the renminbi, creating trade tension between Europe and China. Now China in order to control imported inflation and protectionism in US and European countries; has to appreciate the renminbi. This will, in turn, increase prices at Wal-Mart and put additional pressure on the U.S. consumer.

At the end of book George Soros gives some policy recommendation for the present crisis. He admits that these are not firm policy recommendation but subject for the further discussion. Since author is the strong opponent of bush administration and believes that new initiative are to be expected by the new Democratic US President. Some of the important recommendations of George Soros are that newly introduced financial instruments should be abandoned, more regulations should be introduced regarding credit creation, regulators should be stopped from indulging in such activities which they do not understand, and Fed should play its role in the risk management. All the financial authorities should not only deal with inflation and money supply but also play its role to avoid assets bubble and analyze the credit conditions. George Soros also proposed the creation of clearing house or exchange for credit default swaps (CDS) with a sound capital structure. In order to control the collapse in house prices some additional measures should be taken such as guarantees. These guarantees will help loans modifications, amendment of bankruptcy law, and refinance subprime borrowers.